Question

Suppose an economy open to international capital movements has a crawling peg exchange rate under which its currency is pegged at each moment but is continuously devalued at a rate of 10 percent per year. How would the domestic nominal interest rate be related to the foreign nominal interest rate? What if the crawling peg is not fully credible?

Answer 1

Interet parity conditions holds that the diffrence between the interest rate of two countries should be equal to the expected depreciation or devaluaton of currency. Hence here, expected depreciation or devaluaton of currency is 10 percent annually and this is also the difference between the domestic nominal interest and foreign nominal interest rate. For the crawling peg being not credible, the difference in the interest rates is increased as devaluation is expected to be higher under speculation.